General Topics

Let’s not speculate about speculation in housing markets

Published on January 18, 2018 in the Financial Post

The escalation in urban housing prices in recent years has raised concerns about “speculation,” with some regulators and market watchers pointing the finger specifically at foreign buyers.

The Ontario government, for example, bought the speculation narrative and introduced a new 15 per cent tax that is called the “Non-Resident Speculation Tax.”

Other regulators, including the Bank of Canada, also observed in May 2017 that rising housing prices in Toronto were being driven by “speculation.”

When it comes to real estate, however, drawing the line between investment and speculation is not as clear-cut as it may sound.

If you argue, as we do, that expecting capital gains in return for an investment in an asset does not necessarily make it speculation, then the distinction becomes even more difficult.

Benjamin Graham, the author of famed investing books including Security Analysis (first published in the 1930s), made one of the most frequently referenced distinctions between investment and speculation. Graham and his co-author observed that an “investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Even if property values plunge, the rental income stream generated by investment properties largely holds steady

Unlike investing in stocks, however, in most cases investing in real assets does not carry the risk of losing the principal in its entirety, especially in the long-run. And even if property values plunge, the rental income stream generated by investment properties largely holds steady.

Another feature usually attributed to speculation is the shorter investment time horizon.

Those active in flipping condos, i.e., investing in pre- or under-construction condominiums and later assigning the rights to another investor in a short-period at a higher price could be labelled as speculators, by this measure.

But flippers do serve a productive purpose as they are inherently different from households that acquire housing with the intent to occupy it.

Condo flippers are often the ones who offer the much-needed risk capital in the approval (pre-construction) phase of a project to builders and developers, thus helping them satisfy the pre-requisites set by the banks for larger construction loans.

If the risk investors (condo flippers) leave the market, where will the risk capital come from?

When one acquires the rights to an unbuilt or a recently built unit from a flipper, one is expected to pay more for acquiring a less risky asset. The initial investors (call them speculators if you must) invested earlier not in a house but in an idea or a plan with uncertainties (risk) that would take years to complete. The risk in investing in a yet-to-be-built condo is much higher than walking into an open house and making an offer.

MONEY MAKERS
While there are, no doubt, some people buying existing condominiums who are out to make a quick buck, a large percentage of short-term holders are buying at this pre-construction phase.

The term “speculator” has also been used loosely to refer to private investors who acquire housing and rent it out, but this, we feel, is yet another misappropriation of the term.

Those who invest in housing and then make it available to renters, though being driven by expectations of capital gains in the future, are serving an important economic purpose. They are the primary suppliers of new rental housing in large urban centres. And since the current rents are not sufficient to cover the mortgage, taxes, and other costs associated with owning an investment property, private investors are essentially subsidizing renters, in the hopes that future capital gains will offset the lack of adequate cash flow now.

Forty years ago, Professors J. R. Markusen and D. T. Scheffman analyzed the sudden escalation in housing prices in Canada and the impact of a similar “land speculation tax” in Ontario. They noted that then, too, speculators were being blamed for price escalation without anyone first defining the difference between investors and speculators.

GOOD INTENTIONS
Their solution was to define a speculator as one who buys and sells land (or housing) “without the intention of affecting improvements, or using the land as an input in a production process.”

By that definition, neither condo flipping nor investor-owned rental housing qualifies as speculation: Investors provide housing that generates a stream of rental services, and flippers provide risk capital for new housing development when no one else steps up.

Invoking the “speculator” bogeyman may be good politics, but economically speaking it doesn’t tell the whole story.

Murtaza Haider is an associate professor at Ryerson University. Stephen Moranis is a real estate industry veteran. They can be reached at info@hmbulletin.com.